FINANCIAL MANAGEMENT UNIT 1 Meaning of Financial Management: Financial Management means planning, organizing, directing and controlling the

e financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. Nature of Financial Management : 1. An indispensable organ of business management. 2. Financial management and its function is different from Financial accounting and its function. 3. Centralised nature of finance functions. 4. Helpful in decisions of top management. 5. Applicable to all types of concerns. 6. Financial planning. 7. Financial control. 8. Follow-up. Scope/Elements 1. Investment decisions - includes investment in fixed assets (called as capital budgeting). Investment in current assets is also a part of investment decisions called as working capital decisions. 2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby. 3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two: a. Dividend for shareholders- Dividend and the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise. Objectives of Financial Management The objectives or goals or financial management are- (a) Profit maximization, (b) Return maximization, and (c) Wealth maximization. We shall explain these three goals of financial management as under: (1) Goal of Profit maximization. Maximization of profits is generally regarded as the main objective a business enterprise. Each company collects its finance by way i s s u e o f s h a r e s t o t h e p u b l i c . I n v e s t o r s i n shares purchase these shares in hope of getting medium profits from the company as dividend It is possible only when of of the the

company's goal is to earn maximum profits out of its available resources. If company fails to distribute higher dividend, the people will not be keen to invest their money in such firm and persons who have already invested will like to sell their stocks. On the other hand, higher profits are the barometer of its efficiency on all fronts,i.e., production, sales and management. A few replace the goal of 'maximization of profits' to 'fair profits'. 'Fair Profits' means general rate of profit earned by similar organisation in a particular area. (2) Goal of Return Maximization. The second goal of financial management is to safeguard the economic interest of the persons who are directly or indirectly connected with the company, i.e., shareholders, creditors and employees. The all such interested parties must g e t t h e maximum return for their contributions. But this is possible only when the company earns higher profits or sufficient profits to discharge its obligations to them. Therefore, the goal of maximization of returns is inter-related. 3. Goal of Wealth Maximization. Frequently, Maximization of profits is regarded as proper objective of the firm but it is not as inclusive a goal as that of maximizing it value to its shareholders. Value is represented by the market price of the ordinary share of the company over the long run which is certainly a reflection of company's investment and financing decisions. The long run means a considerably long period in order to work out a normalized market price. The management can make decision to maximize the value of its shares on the basis of day-today fluctuations in the market price in order to raise the market price of shares over the short run at the expense of the long fun by temporarily diverting some of its funds to some other accounts or by cutting some of its expenditure to the minimum at the cost of future profits. This does not reflect the true worth of the share because it will result in the fall of the share price in the market in the long run. It is, therefore, the goal of the financial management to ensure its shareholders that the value of their shares will be maximized in the long-run. In fact, the performances of the company can well be evaluated by the value of its share. The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The other objectives can be 1. To ensure regular and adequate supply of funds to the concern. 2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders. 3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost. 4. To ensure safety on investment, i.e., funds should be invested in safe ventures so that adequate rate of return can be achieved.5. To plan a sound capital structureThere should be sound and fair c o m p o s i t i o n o f c a p i t a l s o t h a t a b a l a n c e i s

m a i n t a i n e d b e t w e e n d e b t a n d equity capital

Functions of Financial Management 1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. 2. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. 3. Choice of sources of funds: For additional funds to be procured, a company has many choices likea. Issue of shares and debentures b. Loans to be taken from banks and financial institutions c. Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing. 4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. 5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways: a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus. b. Retained profits - The volume has to be decided which will depend upon expansion, innovation, diversification plans of the company. 6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc. 7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc. 8. Maximising Firms Value: The prime objective of any function in any organisation is to maximise firms value by taking right decisions so as so finance function. But maximisation of shareholders wealth is possible only when the firm is able to increase profits. Hence, whatever decision a financial manager takes should be with the objective of maximisation of owners wealth.

Financial Decisions: The main financial decisions to be taken by the Financial manager are : 1. Investment Decision: One of the most important finance functions is to intelligently allocate capital to long term assets. This activity is also known as capital budgeting. It is important to allocate capital in those long term assets so as to get maximum yield in future. Following are the two aspects of investment decision a. Evaluation of new investment in terms of profitability b. Comparison of cut off rate against new investment and prevailing investment. Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very significant role in calculating the expected return of the prospective investment. Therefore while considering investment proposal it is important to take into consideration both expected return and the risk involved. Investment decision not only involves allocating capital to long term assets but also involves decisions of using funds which are obtained by selling those assets which become less profitable and less productive. It wise decisions to decompose depreciated assets which are not adding value and utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is calculated by using this opportunity cost of the required rate of return (RRR) 2.Financial Decision: Financial decision is yet another important function which a financial manger must perform. It is important to make wise decisions about when, where and how should a business acquire funds. Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known as a firms capital structure. A firm tends to benefit most when the market value of a companys share maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it may increase the return on equity funds. A sound financial structure is said to be one which aims at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure would be achieved. Other than equity and debt there are several other tools which are used in deciding a firm capital structure. 3.Dividend Decision: Earning profit or a positive return is a common aim of all the businesses. But the key function a financial manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business. Its the financial managers responsibility to decide a optimum dividend policy which maximizes the market value of the firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay

regular dividends in case of profitability Another way is to issue bonus shares to existing shareholders. 4.Liquidity Decision: It is very important to maintain a liquidity position of a firm to avoid insolvency. Firms profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a trade off between profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets do not earn anything for business therefore a proper calculation must be done before investing in current assets. Current assets should properly be valued and disposed of from time to time once they become non profitable. Currents assets must be used in times of liquidity problems and times of insolvency. Financial activities of a firm is one of the most important and complex activities of a firm. Therefore in order to take care of these activities a financial manager performs all the requisite financial activities. A financial manger is a person who takes care of all the important financial functions of an organization. The person in charge should maintain a far sightedness in order to ensure that the funds are utilized in the most efficient manner. His actions directly affect the Profitability, growth and goodwill of the firm. Following are the main functions of a Financial Manager: 1. Raising of Funds In order to meet the obligation of the business it is important to have enough cash and liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a financial manager to decide the ratio between debt and equity. It is important to maintain a good balance between equity and debt. 2. Allocation of Funds Once the funds are raised through different channels the next important function is to allocate the funds. The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the best possible manner the following point must be considered

The size of the firm and its growth capability Status of assets whether they are long term or short tem Mode by which the funds are raised.

These financial decisions directly and indirectly influence other managerial activities. Hence formation of a good asset mix and proper allocation of funds is one of the most important activity

3. Profit Planning Profit earning is one of the prime functions of any business organization. Profit earning is important for survival and sustenance of any organization. Profit planning refers to proper usage of the profit generated by the firm. Profit arises due to many factors such as pricing, industry competition, state of the economy, mechanism of demand and supply, cost and output. A healthy mix of variable and fixed factors of production can lead to an increase in the profitability of the firm. Fixed costs are incurred by the use of fixed factors of production such as land and machinery. In order to maintain a tandem it is important to continuously value the depreciation cost of fixed cost of production. An opportunity cost must be calculated in order to replace those factors of production which has gone thrown wear and tear. If this is not noted then these fixed cost can cause huge fluctuations in profit. 4. Understanding Capital Markets Shares of a company are traded on stock exchange and there is a continuous sale and purchase of securities. Hence a clear understanding of capital market is an important function of a financial manager. When securities are traded on stock market there involves a huge amount of risk involved. Therefore a financial manger understands and calculates the risk involved in this trading of shares and debentures. Its on the discretion of a financial manager as to how distribute the profits. Many investors do not like the firm to distribute the profits amongst share holders as dividend instead invest in the business itself to enhance growth. The practices of a financial manager directly impact the operation in capital market.

EVOLUTION OF FINANCIAL MANAGEMENT Financial management emerged as a distinct field of study at the turnoff this century. Its evolution may be divided into three broad phases (though the demarcating lines between these phases are somewhat a r b i t r a r y ) : t h e t r a d i t i o n a l p h a s e , t h e t r a n s i t i o n a l p h a s e , a n d t h e modern phase The Traditional phase : The Traditional phase lasted for about four decades. The following were its important features of this phase : The focus of financial management was mainly on certainepisodic events like formation, issuance of capital, major expansion, merger, reorganization, and liquidation in the life cycle of the firm. The approach was mainly descriptive and institutional. The instruments of financing, the institutions and procedures used incapital markets, and the legal aspects of financial events formedthe core of financial management. The outsiders point of view was dominant. Financial management was viewed mainly from the point of the investment bankers, lenders, and other outside interests.

The transitional phase being around the early forties and continued through the early fifties. Though the nature of financial management during this phase was similar to that of the traditional phase, greater emphasis was placed on the day-to-day problems faced by finance managers in the areas of funds analysis, planning, and control. These problems, however, were discussed within limited analytical frameworks.

The modern phase: The modern phase b e g a n i n t h e m i d - f i f t i e s a n d h a s w i t n e s s e d a n accelerated pace of development with the infusion of ideas from economic theory and application of quantitative methods of analysis. The distinctive features of the modern phase are : The scope of financial management has broadened. The central concern of financial management is considered to be a rational matching of funds to their uses in the light of appropriate decision criteria. The approach of financial management has become more analytical and quantitative. The point of view of the managerial decision maker has become dominant.

Since the being of the modern phase many significant and seminal developments have occurred in the fields of capital budgeting, capital structure theory, efficient market theory, option pricing theory, arbitrage pricing theory, valuation models, dividend policy, working capital management, financial modelling, and behavioural finance. Many more exciting developments are in the offing making finance a fascinating and challenging field.

Maximising Vs Satisfying : The objective of profit maximisations and maximization of share holders wealth are single point objectives. Though the latter is regarded as the undisputed objective of financial management, yet it may also pore problems in a particular situation. Therefore, the objective of financial management may be taken as a reasonable level of satisfaction both for the shareholders as well as the management. The financial decisions under this approach may be taken in order to protect the interest of both instead of achieving maximum benefit for one of the these two only. The objective of satisfying the shareholders as well as the management is based on promise that the shareholders must get some minimum project within a reasonable level of risk so that the market price of a share is not unduly affected. It is true that it may not be always be possible to achieve the best but a satisfactory level can definitely be achieved.

However defining a satisfactory level of satisfaction for the share holders and the management may itself be tedious job.

Risk Return Trade-off : A finance manager is usually placed between decisions involving risk and return. While making the decisions regarding investment and financing he has to seek to achieve the right balance between risk and return. He should maintain balance between liquidity and profitability of the firm - If he borrows heavily to finance its operations, then the surpluses generated out of operations would be sufficient to service the debt in the form of interest and principal payments. The surpluses or profit available to the owners would be reduced because of the heavy Debt-servicing. If things do not work out as planned and firm is unable to meet its obligations, the company is even expo0sed to the risk of insolvency. Similarly, the various investment opportunities have a certain amount of risk associated with the return and also the time when the return would materialize. The finance manager has to decide whether the opportunity is worth more than its cost and additional burden of debt can be borne by them. The decisions regarding the major areas of financial management i.e., capital budgeting decisions, working capital decisions, dividend decisions, capital structure decisions etc., should be taken in a way such that return in the trade should be more or optimum than the risk and in a way to increase the market value of the firm. This level is termed as Risk Return Trade off.

Profit Maximisation Vs Wealth maximation :

The main goal of the financial manager is to maximise firms profit as well as wealth to the shareholders. The maximation of profit is often considered as an implied objective of a firm. Profit is the remuneration paid to the entrepreneur after deduction of all expenses. Maximization of profit can be defined as maximizing the income of the firm and minimizing the expenditure. The wealth/value of a firm is defined as the market price of the firms stock. The market price of a firms stock represents the focal judgement of all market participants as to what the value of the particular firm is. It takes into present and prospective future earnings per share, the timing and risk of these earning, the dividend policy of the firm and many other factors that bear upon the market price of the stock. The wealth maximisation objective of a firm is superior to its profit maximisation objective due to following :-

Wealth maximisation objective of a firm considers all future cash flows, dividends, earning per share, risk of a decision etc., whereas profit maximisation objective does not consider the effect of EPS, dividend paid or any other returns to shareholders or the wealth of the shareholders. A firm that wishes to maximise the shareholders wealth may pay regular dividends whereas a firm with the objective of profit maximisation may refrain from dividend payment to its shareholders. Shareholders would prefer an increase in the firms wealth against its generation of increasing flow of profits. The market price of a share reflects the shareholders expected return, considering the long term prospects of the firm, reflects the difference in timings of the returns, considers risk and recognizes the importance of distribution of returns. The maximisation of a firms value as reflected in the market price of a share is viewed as a proper goal of firm. the profit maximisation can be considered as a part of the wealth maximisation strategy.

Profit maximization objective is a little vague in terms of returns achieved by a firm in different time period. The time value of money is often ignored when measuring profit. It leads to uncertainty of returns. Two firms which use same technology and same factors of production may eventually earn different returns. It is due to the profit margin. It may not be legitimate if seen from a different stand point. Financial Goal - Profit vs Wealth

Every firm has a predefined goal or an objective. Therefore the most important goal of a financial manager is to increase the owners economic welfare. Here economics welfare may refer to maximization of profit or maximization of shareholders wealth. Therefore Shareholders wealth maximization (SWM) plays a very crucial role as far as financial goals of a firm are concerned. Profit is the remuneration paid to the entrepreneur after deduction of all expenses. Maximization of profit can be defined as maximizing the income of the firm and minimizing the expenditure. The main responsibility of a firm is to carry out business by manufacturing goods and services and selling them in the open market. The mechanism of demand and supply in an open market determine the price of a commodity or a service. A firm can only make profit if it produces a good or delivers a service at a lower cost than what is prevailing in the market. The margin between these two prices would only increase if the firm strives to produce these goods more efficiently and at a lower price without compromising on the quality. The demand and supply mechanism plays a very important role in determining the price of a commodity. A commodity which has a greater demand commands a higher price and hence may result in greater profits. Competition among other suppliers also effect profits. Manufacturers tends to move towards production of those goods which guarantee higher profits. Hence there comes a time when equilibrium is reached and profits are saturated.

According to Adam Smith - business man in order to fulfill their profit motive in turn benefits the society as well. It is seen that when a firm tends to increase profit it eventually makes use of its resources in a more effective manner. Profit is regarded as a parameter to measure firms productivity and efficiency. Firms which tend to earn continuous profit eventually improvise their products according to the demand of the consumers. Bulk production due to massive demand leads to economies of scale which eventually reduces the cost of production. Lower cost of production directly impacts the profit margins. There are two ways to increase the profit margin due to lower cost. Firstly a firm can produce at lower sot but continue to sell at the original price, thereby increasing the revenue. Secondly a firm can reduce the final price offered to the consumer and increase its market thereby superseding its competitors. Both ways the firm will benefit. The second way would increase its sale and market share while the first way only tend to increase its revenue. Profit is an important component of any business. Without profit earning capability it is very difficult to survive in the market. If a firm continues to earn large amount of profits then only it can manage to serve the society in the long run. Therefore profit earning capacity by a firm and public motive in some way goes hand in hand. This eventually also leads to the growth of an economy and increase in National Income due to increasing purchasing power of the consumer.